The IMF fears underfunded pension funds could be
encouraged to chase returns through riskier investments such as direct credit
exposure or by engaging in securities lending in order to improve their funding
ratios….The IMF’s comments echoed similar warnings from the OECD in May, when the Paris-based body said pension
funds’ move towards riskier asset classes could result in their solvency position being “seriously compromised” in turbulent
markets. The Financial
Times

Yesterday I published a post in which I outlined the
reasons why pension fund underfunding is likely much worse than the level
admitted by the funds themselves and industry professionals. The biggest
culprit is “mark to market” of illiquid investments into which pension managers
have “shoe-horned” themselves in order to give the appearance of rates of
return that are higher on paper than in reality. A good friend and
colleague of mine, who happens to be very bright, had this comment in response
to my post:

Pension funds are collectively insolvent.
Basically the asset managers running these funds have refused to MTM them
properly, expecting the assumed X% annual return to normalize. Sorry,
buddy: this IS the new normal (which is why the unfunded situation gets worse
every year… assume 8% and get 0% for enough years and the chasm only widens… in
fact, by the rule of 72, your funding gap will double every 9 years if that 8%
gap is reality). This is where the rubber hits the road, the issue which
is going to punch the middle class in the gut like a steel 2×4.

This is the same dynamic that torpedoed the big bank
balance sheets when the housing/subprime credit bubble popped, as big chunks of
home equity, mortgage and other credit products were marked close to par when
in reality most of it was worth zero. And this is one of the primary reasons
that the Fed is devoting significant resources to keeping the stock market
propped up: pension fund insolvency is at risk.

One of the biggest areas of concern for pension funds
is their private equity investments. Most pension funds have been literally
“throwing” cash at private equity firms who have been shoveling money into real
estate rental schemes and, even worse, have fueled the private market Silicon Valley
bubble.

No one ever admits to a bubble until after it’s popped
and has destroyed trillions in value – just ask Alan Greenspan and Ben
Bernanke. Bernanke never saw the housing bubble that he and Greenspan
blew and Janet Yellen can’t see the tech bubble that she and Ben inflated.
Fortunately for Ben, Yellen will get tagged with the Silicon Valley
collapse.

It looks like the process has begun. Dropbox
tried to IPO at
its private market valuation of $10 billion and had to pull it, as the public
market disagreed with BlackRock, who led the last round of funding for Dropbox.
Dropbox has revenues of a little more than $200 milion and zero net
income. The $10 billion valuation was insane. But the game is over
now.

As more Silicon Valley “unicorns” fail to monetize at
levels even remotely close to their private market bubble value, the value of
the private equity holdings of pension funds will vaporize. The valuation
process for a tech start-up is typically a “bi-nomial” function. It
either works and is a home run or it’s worth close to zero because the
company’s technology will never generate income (Amazon?).

This implies that private equity holdings held by
pension funds are significantly overvalued on the “mark to fantasy” basis and
will eventually be subjected to massive valuation write-downs. It’s a
vicious negative feedback loop that is magnified by the “leverage effect”
created by the existing level of pension fund underfunding.

Here’s what the problem looks like visually (source:
Zerohedge):

This graphic shows five of the steepest declines in
stock price for tech companies IPO’s in the last few years. Note that the steep decline occurs since
2014. This means that private equity funds with investments in comparable
companies have mark down their private market holdings to reflect better the
valuations given to these companies in the “cash out” market. This also means
that pension fund private equity fund holdings are likely already significantly
overvalued.

As for real estate? One of the primary source
of funds for the buy to rent portfolios amassed by private equity firms like
Blackstone has been pension funds. A recent mergerof two public buy-to-rent REITS valued one of the
entities’ current home rental portfolio at 50% of its original carrying (i.e.
investment) value. As with tech p/e investments, this transaction
effectively revalues down significantly pension fund investments in this
sector.

The bottom line is that pension funds are already
significantly underfunded. Recent developments in the real estate and
tech investment private equity market suggest that the level of underfunding is
about to be bludgeoned.

Dr. Paul Craig Roberts was Assistant Secretary of the Treasury for Economic Policy and associate editor of the Wall Street Journal. He was columnist for Business Week, Scripps Howard News Service, and Creators Syndicate. He has had many university appointments. His internet columns have attracted a worldwide following. Roberts' latest books areThe Failure of Laissez Faire Capitalism and Economic Dissolution of the West